The libertarians who want to BAN fractional-reserve banking

I hate to disagree with other libertarians. But there’s a group of them who are getting the banking system really wrong, and their superficially attractive thesis is causing all manner of confusion. These are the Rothbardian campaigners who claim that fractional-reserve banking is theft. They say that this evil and sinister system must be wiped off the planet.

So what exactly do they oppose? At present, when you deposit £1000 into your current account, the bank lends some of that money. The cash is used, for example, to provide a mortgage to a first-time buyer or give finance to a small business wanting to expand. The Rothbardians claim that this is fraudulent. Actually, this is a perfectly reasonable thing for banks to do. It creates economic growth by giving businesses and individuals access to finance. And, frankly, everyone knows that banks lend out deposits: there is no fraud involved at all.

What the Rothbardians want is for a bank to take your money and leave it untouched in a vault. But banks already offer this: they rent safe deposit boxes – not that many people use them, and those who do tend to put jewelry and other valuables in them.

Instead of supporting a free market, the campaigners demand the criminalisation of fractional-reserve banking – they want to strip consumers of a choice over where they deposit their cash. This is a breathtakingly unlibertarian position for a bunch of supposed libertarians.

In fact, fractional-reserve banking is just a result of market forces, going back to the bankers in of Genoa and Venice in the 12th century, who lend out their deposits.

Conversely, according to the Austrian economist Prof George Selgin, every significant bank in history that just sat on deposits “was a government-sponsored enterprise, which depended for its existence on some combination of direct government subsidies, compulsory patronage, or laws suppressing rival (fractional reserve) institutions.”

We already have enough financial socialism. Do we really want to ban a banking custom that consumers, through history, have chosen?

July 29th, 2011 |

77 comments to The libertarians who want to BAN fractional-reserve banking

If the bank then runs in to trouble due to maturity mismatching (i.e. the at call depositors want their money now, but the bank cannot get the money back from borrowers with 25 year fixed term loans) then the bank should not be bailed out and should be allowed to go bust, however. Depositors should know this and understand that they are taking this risk when they deposit their money. Depositors who do not wish to take this risk should deposit their money in banks without such mismatched maturities, a situation that banks can achieve easily enough by trading in the derivatives markets and/or encouraging fixed term rather than at call deposits.

All this should be clearly understood, and is absolutely fine as long as everyone enters into this freely. And as long as government sticks out of it and we avoid mismanagement of risk as a consequence of implied or explicit government guarantees.

Okay, monetary policy isn’t my strong suit, but I thought the concern wasn’t that the deposits were lent out, but that the banks were lending out more than the value of the deposits, that banks were only required to have a given fraction of a dollar in deposits for every dollar in loans, with the remainder being borrowed from the central bank issuing the currency.

I thought that this is what was meant by “fractional reserve”, and that those opposing fractional reserve did so because it put banks and depositors in greater peril, and allowed the central bank a greater ability to create inflation by increasing the money supply this way.

Michael beat me to it: the only issue here is informed consent, nothing else. However, as things stand now and have been standing for as long as I don’t know what, such informed consent is not present with most private depositors: most people simply don’t understand how the system works, and neither banks nor government overseers are taking any pains to change that – I wonder why. Please move along, nothing to see here.

Those are not libertarians they are Milibandists and Obamessiahists. The only dafter idea I have heard was on an American ‘liberal’ website where the sheeple were saying Obama should reduce the deficit and welfare spending by hiring millions more people onto the public payroll. I thought everyone with a brain understood how the both the banking system and the public sector deficit worked.

I agree with Michael in that the key to this is whether fraud is happening.

I lend money to a bank, or, I entrust my money to a bank.

Is it made clear which I am doing?

And, if I am lending money to a bank, does the bank then make promises to others, on the basis of what I have lent it, in the form of its own notes and promises and “money” created “out of thin air” (as the opponents of fractional reserve banking like to put it) that I don’t get told about? I might vehemently object to if I did know, but I might be willing to take a chance on it anyway. What matters, as my late mum used to say in her lobbyings concerning what sort of childbirth treatment women got in hospitals, is informed consent.

But Alex is right. Stupidity, if that is what fractional reserve banking is, should not be illegal, merely because it is stupid. Force and fraud should be illegal. Foolishness, absolutely not.

Just so long as everyone involved is legally expected to live with the consequences of their actions, and is willing to suffer their losses if their bets go bad.

Thank you for bringing this issue up. I think, we in the western world, really need to educate ourselves on this topic. Just so happens, I’m reading the Creature from Jekyll Island right now, which I highly recommend to your readers. As I understand it, (and I can only speak through my own American prism), is that our central bank it is a private monopoly in the hands of a few individuals. Why can’t our governments print our own money? Why do our governments have to borrow from a private monopoly? We pay for the borrowing of money via inflation, which is an incremental slow burn of wealth. It inviserates the middle class over time and ultimately takes a war to clear the decks.

Thank you for starting this discussion. I believe, we in the western world, really need to educate ourselves on this topic. Just so happens, I’m reading The Creature from Jekyll Island, which I highly recommend to your readers. The problem with central banking (and I can only see through my own American prism) is that it is a private monoply. Why can’t governments issue money? Why do governments have to borrow through a private entity? We pay for the borrowing via inflation which inevitably eviserates wealth and the middle class over time. And it appears it takes a war or some other crisis to clear the decks.

Kathleen, the government is printing its own money (although it is expressly forbidden to do so by the US Constitution), as the Federal Reserve is a private organization in name only. It is, for all intents and purposes, part of the Federal Government.

I used to be a Rothbardian anti FR hawk but have seen the light. It is really the central banks that have casued the problems by “setting” interest rates.

If interest rates were set by market interactions then market confidence in fractional reserve deposits would be much lower with the risks of a run factored into the price (interest rates). This in turn would force the banks to make sure that thier reserve ratios were conservative enough to keep investor confidence. This would stabilse the elasticity of money/credit far better than a central bank and therefore lessen the impacts of the business cycle.

At current reserve ratios, if one person in 34 (less than 3% of depositors) was to withdraw all their deposits then we have a bank run. Far better if it was 1 in 10 – whatever the market deems stable.

Different banks will have different rates depending on ratios. However, you would have to repeal/ammend banking laws/regs to allow more banks to compete so that there was a genuine market, not the cartel we currently have.

Taking money placed in a demand deposit and lending it out to a mortgage borrower for say, 25 years, is not “a perfectly reasonable thing to do”, Alex. The issue is confused by conflating demand deposits and time deposits.

Also, there are people who claim that banking is all about “maturity transformation”, but that ignores the need to avoid serious mismatches between say, a guy who puts cash in a no-notice account – where that money should not be lent out for years – and someone who puts it in a long term investment vehicle on the understanding that there is a penalty for instant withdrawal.

In other words, the key issue here is time. And of course, any reading of Austrian economics tells us that time is a key aspect of the Austrian understanding of what capital is.

Separately, I am of the view that while fractional reserve banking is often a “fraud”, it is only so if people do not have what goes on properly explained. in a world of free banking, and, crucially, absent taxpayer bailouts, legal tender laws, and central banks, the sort of FRBs that now operate would, in most cases, either go immediately bust or have to dramatically change course.

In other words, let free markets operate as fully as possible. “I may be a dreamer, but I’m not the only one”……

Missing in most of these kinds of discussions (including a lot of the Ron Paul type) is a necessary premise:

What is the essential function of banking in a particular form of “economy?”

What function(s) make banking the most effective and efficient in a particular form of “economy?”

In an “economy” where most of what serves the functions of money is credit it is difficult to conceive of a cost-efficient credit system where all credit providing (or assuring) facilities would be able to maintain an absolute equilibrium of obligations to claims (or assets) by timing or amounts consistently.

It would seem possible that there could be a better balance between the nature of obligations and the quality of claims (or assets). We still seem to be a long way from resolving, even partially, that issue.

A bank could have 100% claims and assets matching in timing and form its obligations. But, it is the quality of those claims and assets that are determinative of its depositary function.

We are now seeing that “even” sovereign debt has questions of quality.

The real problems probably arise from the fact that banks are no longer the principal forces in determining the deployment of capital in most modern economies.
That function has largely transferred to the managerial class.

Restricting Bank of England guarantees to only those banks that keep the funds to repay depositors would seem a less irresponsible use of public money than what we have now.

In that case the Bank of England guarantees are insurance against the money being physically stolen, but not much more than that. Such insurance can and should be purchased on private markets.

I do not want the Bank of England, or regulators deciding what kinds of banking is best and hence protected. They are not smart enough to figure this out. The market should decide this. Banks should be able to operate any way they wish to, and the market should decide what is best. Protection of depositors is something that banks should purchase from other market participants (assuming that their customers want it), not something that should be provided by governments.

Government guarantees and and regulation has caused a banking collapse, yet, but ever worse than that, it has removed all market signals. A high rate of return should indicate high risk. A low rate of return should indicate low risk. The right classes of investor will choose the right classes of investment because of this. Without these, signals, the result is massive misallocation of capital. Which is what has in fact happened.

Interestingly this discussion recently came up in the comments at David Friedman’s blog. George Selgin even chimed in to say:

David [Friedman], for the record, I don’t “describe myself as an Austrian,” and haven’t done so since graduate school. Indeed, I consider myself no less a fan of your dad’s work than I am of work by Hayek and Mises. I think a good economists cannot concern himself or herself with belonging to any school, or being loyal to one.

Every time a bank statement comes through the door it reinforces the idea that you “have” money in the bank, sitting around waiting for you. The bank talks about it being “your money.” The vast majority (I guess) of people don’t think of money in the bank as the banks money to do what they want with a promise that they will return it (if they can).

So people don’t know what is legally happening when they deposit money, nor are the utterly free in their decisions.

Legal rules makes it almost impossible to operate without a bank (try buying a house with a suitcase of cash). Inflation means that not using a bank is an expensive proposition.

Until these issues are resolved, I’m not surprised that people try to ban what appears to be the presenting issue.

Legal rules makes it almost impossible to operate without a bank (try buying a house with a suitcase of cash). Inflation means that not using a bank is an expensive proposition.

Yes. Banks have also been granted monopolies over the running of national payments systems. This is bad, and yet another way in which government has screwed things up. (Transport for London would have loved to have turned the Oyster card that is used to pay for fares on public transport in London into a more general payment card, but was prevented from doing this by government regulation. Essentially they had to agree to apply and be granted a banking licence and then agree to be regulated by the FSA before they could do this. I think that they eventually gave up).

Taking money placed in a demand deposit and lending it out to a mortgage borrower for say, 25 years, is not “a perfectly reasonable thing to do”, Alex.

Oh, certainly it is, as long as you can convince depositors of the soundness of your management, and thus avoid a bank run. If you do not, there will be a bank run and the bank will collapse. This is bad for the bank, but not necessarily bad for the banking system.

A bank that does this will be able to offer higher returns to its depositors than a bank that matches the maturity of its deposits and its loans. Matching these things is not difficult and we have all manner of financial markets that exist to do things like this, but the act of matching these things costs money. Essentially, a bank with matched maturities is a bank without matched maturities plus some insurance. Insurance should be optional, and depositors should have the choice of whether to buy it or not. And they should have the freedom to suffer the consequences of their actions if they do not.

“At present, when you deposit £1000 into your current account, the bank lends some of that money.”

That is not my understanding of fractional-reserve banking. What the bank does is lend out your money many times. No, that is not a misprint. They take your £100 and lend out £300. I’ve heard cases of a ratio of 1:100. That’s where the word “fractional” comes from.

Rothbard’s view was that if you want lending then the answer is a ceritificate of deposit in which you lend the bank a specified amount of money for a specified length of time. Otherwise banks should be nothing other than money warehouses.

Having said that I am with Selgin. Laws (including fraud laws) are a form of intimidation. Intimidation is a form of violence and violence is wrong.

A bank lends out some of the money deposited, it does not lend it out many times. The point is that the banking system created an amount of bank balances (which are a money substitute) many times greater than the initial deposit.

So, suppose I lend £400 to a bank by depositing notes. It could lend out £300 of that. I then have a balance of £400, and the borrower has £300. Then the borrower buys something with his loan and that £300 is deposited in another account. The holder of that account then has a £300 balance, and the notes are lent out again by that bank.

Notice that in the long run this reaches an equilibrium which depends on the following things:
* demand & supply for base money (notes, coins and reserve).
* demand & supply for bank balances.
* the demand for loans & supply of fixed term loans (ie bonds).
The multiplication doesn’t continue forever.

One of the big problems is that almost no one seems to understand how fractional reserve banking works, in a mechanical sense, and so a lot of statements about it turn out to be utter nonsense.

No, banks that get $1000 in deposits don’t get to immediately loan out $9000 when the have a 10% reserve requirement, simply because of that $1000 deposit. The mistake is in thinking in simplistic terms and sound bites.

But to *start* out simply, let’s say there’s only 1 bank in the world, where everyone immediately deposits all money they receive, and that there’s only $1000 in the world as well, which starts of belonging to A. Further assume the reserve requirements work the way they actually currently work.

“A” deposits $1000. The bank can’t loan out $9000 yet, as it needs to keep at least $100 on deposit to cover the reserve requirement on the $1000 deposit. However, when they loan out the $900 to B, remember that everyone immediately deposits any money they receive at this bank.

So B deposits that $900. The bank can’t loan all of that, but it can loan $810 of it to C and retain $90. C deposits it, and the bank loans $729 to D. And so on an so on, and so on. At each step, the bank accumulates a bit more of the cash in their “reserves” to cover the deposits people have made.

After an infinite number of steps :-), the bank has all $1000 of the “real money” in its “reserves” and has loaned out a *total* of $9000, and has a total of $10000 “on deposit” from that original $1000 deposit, now covered at 10% by the $1000 reserves.

The bank doesn’t get to skip any of those steps. The reason that it *looks* like they can skip all the steps is that, in fact, there are hundreds of banks, and millions of depositors, and a lot more money than they bank has on hand is flowing through the system at a ridiculous speed, so that “infinite” number of loans actually takes place in a very short time.

But if someone comes in and withdraws $100, everything does have to grind to a halt until another person deposits $100 to replenish the reserves. It’s just that this happens almost instantly.

The bank doesn’t print any new money… it can only loan out real money that’s actually sitting in its reserves.

First of all, when we hear those money multiplier ratios bandied about, this does not mean that money has been created out of thin air. The broad money statistics represent accounting entries on the books of the banking system. It is not money as such but a measure of the level of credit that is being extended. A high degree of credit is a good thing if the money is being invested in high quality investment projects. It is a bad thing if it is being used to buy gin.

This is all there is too it.

An improvement to the banking system could be made if it was made clear that the money in demand deposits would not be lent out (“narrow banking”), and that money in savings deposits were at risk – just as is the case when you invest in a money market mutual fund (although these are often ‘single priced’ and do usually pay money on demand, they often have ‘gating’ arrangements in place whereby the provider has an option to deny payments for, say, 3 months, or whatever is in the legal documentation. The Scottish banks in the free banking era had such arrangements in place).

Note however, that such a change would not necessarily lead to a reduction in the overall level of credit in the economy. There are already reserve requirements in place and these are being tightened up, which will achieve much the same thing, although without the benefit of informing the public that their savings are not technically money.

The problem is not fractional reserve banking (and the Scottish banks I mentioned earlier operated with low, say 3%, reserve ratios), but the role of the central bank in all of this. There is first the issue of the printing of money (which the bank does on an ongoing basis by lending out money that is created ex nihilo at its stated interest rate). This potentially leads to excessive credit expansion. More serious to my mind is the severe moral hazard that the banking system suffers from, which is the result of the government underwriting the solvency of the banking system. This, in combination with the printing of money effect, leads, I believe, to the boom and bust credit example, as per the Austrian explanation.

Perhaps I missed it, but nobody here seems to have mentioned real world examples of private fractional reserve banking, of which the obvious one is the Scottish free banking system of the 18th century, described by Adam Smith. The banks were private firms issuing currency redeemable in silver. In order to issue 1000 ounces worth of currency the bank doesn’t need 1000 ounces of silver. All it needs is at least 1000 ounces of assets–preferably interest bearing ones–and enough silver so that if depositors come in with currency, the bank can redeem that currency, then sell other assets in order to buy back some of the silver it has paid out, and use that for the next depositors.

Further, at least some of the banks included on their notes an option clause, stating what penalty they would pay if they were unable to redeem a note when offered and had to delay redemption for (I think) six months. That made it clear that there was some risk of a run on the bank delaying redemption. And the banks reduced that risk by being structured as unlimited liability partnerships, with one of the partners typically a wealthy landowner.

What the anti FR position argued by Rothbard and some of his supporters claims is that all such contracts are fraudulent, and so should be banned. If so, all insurance contracts should be banned as well, since if all the insured houses happen to burn down in the same year the insurance company won’t have the money to pay off on them. Similarly for many other contracts where there is some risk that one party or the other will be unable to fulfill his obligations.

But talking about fractional reserve banking in a government run fiat system simply confuses the issue, since Rothbard et. al. were arguing that private FR banking should be banned.

Maybe it is heresy, but I know nothing of Rothbard’s advocacies. If it is true that they want to ban all exchange systems that permit fractional reserve lending, then that is hardly libertarian. But if they are only saying that they want to prohibit fractional reserve banking using currencies issued by a different, non-consenting party, then if that issuing party contractually prohibits its users from engaging in fractional reserve lending, that stipulation should bind all users. I’ll attempt to explain why.

PeterT’s assertion that money has not been created out of thin air is false. It has. How much is created is measured by the various M0-3 money measures. Fractional reserve lending dilutes the value of the already existing currency. This effect is moderated to some extent by ‘float’ time, the time money spends outside of the deposits system. Physical paper and coin in private hands is not multiplied. But in our electronic, nearly cashless society, money almost never leaves the system therefor cash almost never leaves the vault. The useful/usable amount of money as inflated by the fractional reserve multiplier. Hacksoncode explains it above and Wikipedia explains it with a chart.

If I start a private bank and issue a new currency, I will certainly stipulate the conditions under which its users may engage in fractional reserve lending/borrowing. If I print one hundred thousand ‘one ounce of gold’ certificates and I have one hundred thousand ounces of gold to back them, I am entitled to announce that each of my certificates is backed by one ounce of gold. If, however, competing banks begin fractional reserve lending of demand deposits of my certificates (time deposits are not FRR if they are matched to the time of the loans) then there could be people claiming the rightful ownership of one million ounces of gold when there are only 100 thousand. Key word ‘claiming‘.

There are two modes this effects users of those gold certificates. First, I only accept genuine original gold certificates so it is possible (barring a caveat emptor for the depositors) that in the event of a run their bank defrauded them. Not my problem, that’s between them and their bank. All I promised was to exchange my original certificates for gold. But there is another factor. People who never deposited or borrowed fractionally reserved certificates are still effected. There are now one million certificates (100,000 real and 900,000 virtual) chasing the market with each holder of them believing they are worth one ounce of gold. Except they aren’t. They are only worth 1/10 ounce of gold. If the bank never misjudges their certificate withdrawal demands, they don’t fail, but they still generate a ten fold increase in the perceived number of one ounce gold certificates chasing the market. When you inflate some of the currency, you are devaluing all of it. Barring bank failure, my certificates of been greatly diluted in value. If I only have a very small market share the effect is negligible. But if I have a major hunk of market share, holders of genuine certificates have a share of the value of their certificate transferred to the holders of virtual certificates. Lending a competitors currency at fractionally multiplied rates can diminish that competitor’s market standing. So when I issue my currency I should stipulate that it may not be used that way.

These consequences apply even if for physical gold instead of certificates. If there are 10 million total ounces of gold in an economy and banks fractionally lend that physical gold at a 10% fractional reserve rate, the value of true gold coin is reduced to the exchange value it would have if there were 100 million ounces in circulation. From time to time the market would probably get spooked and run the banks and a lot of demand deposits would be wiped out (unless deposit insurers are also alchemists) and depositors would learn their lesson once every two or three generations.

So, perhaps there is more to the Rothbardians case than it would first appear. However, since nobody can be granted a legal monopoly on all gold, we just need to accept that there are bankers somewhere inflating gold stocks and devaluing genuine coin. It is even possible that in a Life, Liberty and Property libertarian society, participants seeking to avoid fractional reserve modulated inflation/deflation would choose a private fiat (yes fiat) currency that contractually stipulated that all lending in that currency must be from matched time deposits.

Any prohibition of fractional reserve banking in gold coin and bullion requires that all gold first be classed as community property and its use licensed by the government, much as LVT first presumes community property of land and then licenses its use.

And the banks reduced that risk by being structured as unlimited liability partnerships, with one of the partners typically a wealthy landowner.

Isn’t that the practical equivalent of full reserve? As long as somebody had the assets to guarantee the deposits, the deposits are guaranteed as though fully reserved but with an asset liquidation time lag. The wealthy landowner has basically put down his land as collateral to back the loans he made. That seems to me to be a very strong structural incentive for cautious loan management, no?

First of all, when we hear those money multiplier ratios bandied about, this does not mean that money has been created out of thin air. The broad money statistics represent accounting entries on the books of the banking system. It is not money as such but a measure of the level of credit that is being extended.

[emphasis mine]. Peter (and Mid?), isn’t ‘credit extended’ the same thing as money, going by money’s historical, original definition – i.e. ‘IOU’? I do agree with your actual point, though (if I in fact understood it correctly) – which is, money being created “out of thin air” is not the problem (it being the actual nature of money) – the problem is the legal-tender environment, or, in other words, the de-facto prohibition of free market in currencies.

As to FRB: as Mid explained, it can in fact devalue a particular currency. But in a free-currency, no-legal-tender market, this problem would not reach anywhere near the current proportions: as soon as a particular currency, no matter how popular and widely used, became inflated beyond a certain level, users would begin fleeing it in favor of competing currencies.

More than ‘credit extended’ it is useful to think of money inside the banking system and money outside of the banking system. In commodity based currencies (gold, silver, platinum, palladium, etc) that means actual jingles in your pocket gold as opposed to a bank balance of ‘gold’. In a ‘paper money’ system, it means the actual possession of Fed (or whatever) paper notes and coins versus a bank balance indicating that you have them on deposit in your account.

Nobody carries ‘real’ money anymore. Almost all money lives inside, not outside the banking system. Virtually all economic activity occurs as either debit or credit banking transactions. Any money that is valid in the electronic system has the same effect on the economy as physical currency would. The fact that they are fully exchangeable at par demonstrates this. So when measuring inflation/deflation as dollars-per-consumer the only value that matters is electronic quantity. In commodity money systems (gold,etc), a universal bank run on demand deposits results in a (at 10% FRR) 90% reduction in apparent money as only real commodity counts. This is called ‘deflation’ or ‘monetary contraction’. In a fiat system the issuers of the fiat currency have the option of printing the 90% shortfall that occurs in electronic money. What they do is they print ‘real’ money to take the place of the money that depositors are pulling out of their accounts. This is a desperation move because the only alternative is to deny the depositors the return of their demand deposits. The currency issuing authorities are able to avoid the short term deflation or monetary contraction and all the depositors can withdraw their deposits, but the 900% question is what happens when the market recovers and potential depositors put both the original and newly ‘printed’ money back into the banks.

In a way it creates a self limiting situation once the market starts to recover as people see the incipient inflation and pull their money out of banks and exchange it for ‘non-money’ aka ‘stuff’. This creates a stagnant economy up until the issuing authority’s total printing exceeds the amount of the original money multiplier. If it hasn’t already by that point, by then the velocity will go all Weimar.

Mid, unless I am missing some other point, you seem to be merely making a point for commodity-based currency. I, on the other hand, am reaching the conclusion that this will not solve the problem, at least not in the longer run. The only way we can have a sound money system is by abolishing the central bank and opening the market to competing currencies.

All I ask is the fractional backing of any note be printed plainly on the note. Notes presented as fully backed is not so much a fraud on the depositor as it is fraud upon the person the depositor does business with.

I suppose one could say the vendor takes a risk, caveat emptor, but a simple law mandating transparency doesn’t seem like to big a limitation on anyone’s freedom.

Alisa, not at all. Since the topic of the thread is fractional reserve banking and FRB is inextricable from its effects on the currency being banked, I stayed more less on that topic. Certainly commodity based money systems have much intrinsically to recommend them, but the only way to eliminate FRB driven inflation/deflation cycles is with a contract based ‘paper’ currency that stipulates lending behavior of its users. Some users in a free market will elect to use fiat currencies with very good reason when they think it suits their needs.

But on your bigger question, yes. Monopoly central banks should be banned. There is no monopoly without government force backing it and without government agents forcing everybody to use the ‘private’ Federal Reserve Note system and punishing, imprisoning and confiscating all other private currency systems, we would have no problems. We all would have long since abandoned Fed notes.

But without a government monopoly currency it would be impossible to enforce most of redistributionist government not least starting with the 16th amendment.

Isn’t that the practical equivalent of full reserve? As long as somebody had the assets to guarantee the deposits, the deposits are guaranteed as though fully reserved but with an asset liquidation time lag.

That’s not so different from the current situation. The law doesn’t allow banks to operate while bankrupt, they must hold more assets than they do liabilities. That’s why the loan books of banks are almost always larger than the total of bank balances at that bank. When they aren’t other assets make up the difference. The difference between the assets and liabilities is owned by the shareholders, so it’s called the shareholders equity. In terms of *assets* rather than *reserves* all banks are >100% reserved. That’s not what Rothbardians are attacking, they believe that assets don’t matter and only reserves matter (and they are wrong).

However, in our current world the difference often isn’t that great, banks often work with very little shareholders equity. That means that if loans go bad then current account holders are soon in trouble. Or they would be if it wasn’t for deposit insurance. Ultimately banks have little shareholders capital today because deposit insurance means that current account customers don’t have to choose a solid bank. I think someone showed me the accounts of a UK bank that had shareholders capital of ~1% of total assets. The point David Friedman is making is that during the period of Scottish Free banking this amount was much, much greater. That’s because free banking concentrated the minds of depositors on finding solid banks instead of chasing risky high returns.

BTW, if you are still following the thread, good luck with studying this, Kathleen. I didn’t begin to make headway until I started drawing boxes and arrows and names and values on paper while reading all of the explanations. Than I ran sample transactions on my models. Eventually everything begins to fit together and you will discover certain intuitions are incorrect. For me the most difficult part wasn’t learning what was going on, it was abandoning ‘common sense’ and opening up to a sometimes counter intuitive way of doing things. You will also discover a lot of what is written is wrong or incomplete and so misleading. Just keep comparing lots of sources and drawing diagrams. Eventually you’ll be able to tell what fits and what doesn’t.

The contributors to Wikipedia have been doing a real good job of explaining this. Ignore the complicated math and look at the graphs and read the descriptions/explanations. They are pretty rigorously challenged among the contributors so pretty reliable and accurate.

You’re right, Current, not so different. But as we are talking about available-on-demand deposits, there is a big difference between ‘available on demand’ which requires cash on hand, and time deposits which of course allow time for liquidating assets without violating the depositors contract. Regulation ‘Q’ (in the US) used to restrict pretty much everything that wasn’t protected by FDIC which meant that assets were a reasonable way of honoring deposits. But without that ‘seven days to find the cash’ option then assets should not be considered the same as full reserve. Also, I certainly hope assets are valued significantly more than liabilities as the prices received at ‘fire sales’ to resolve liquidity crises are almost always going to be less than full value.

In my comment to David Friedman my point was two-fold the primary one being about risk assessment by loan writers.

The wealthy landowner has basically put down his land as collateral to back the loans he made. That seems to me to be a very strong structural incentive for cautious loan management, no?

Yes, free banking concentrates the minds of depositors, but with that kind of skin in the game, I think it was more than just free banking concentrating the minds of the bankers. Which goes back to your point about shareholder equity/capital as a percent of total assets. And of course, FDIC style risk transference anesthetizing the diligence of the bankers as well as the depositors.

Current, that’s not correct (at least, not in the US). Most banks have loan-to-deposit ratios of less than 1.00 (which means that they have fewer loans than deposits, not more). The rest of the balance sheet consists of cash, securities and other investments.

But you are right that banks cannot continue to operate if they are bankrupt. I don’t know where you got that 1% figure, but in the US the basic rule is that a bank with less than 3% capital is likely to be shut down very soon.

The problem is with the measurement of “capital”. There are lots of games that can be played with that, some perfectly within the rules (i.e., a certain amount of goodwill, deferred tax assets and other intangibles can be counted as “capital”, but try liquidating them to pay depositors). And even good old shareholders equity, the primary component of capital, can be overstated simply by overvaluing the assets on the books (such as carrying a loan at full face amount when you know it could not be sold at that price and you have doubts that the supporting collateral is adequate). In theory that differential is covered by the “loss reserves”; in practice many (most?) banks have grossly inadequate reserves so their capital is overstated.

But I absolutely agree with you about deposit insurance. A certain amount may be beneficial; it certainly it has done a good job of preventing bank runs since its introduction in the 1930s, and in my opinion there is merit in not requiring small depositors to worry about the condition of the bank. But the present level of insurance (in the US, technically it’s $250,000 but practically it’s unlimited) is far too high. That removes a very important market governor.

Last year a SQOTD was an extended extract from Kevin Dowd’s Alchemists of Loss about this issue. It’s worth revisiting.

FRB should not be banned, and the attempt will set in motion an instance of controls breeding controls. Certainly, one can argue for proper legal re-recognition of “deposit” and related words in their proper meanings, but a ban on FRB ultimately requires a ban on negotiable instruments (eg Bills of Exchange) in order to be effective because FRB can be reconstructed *in full* from the perfectly legitimate legal principles applicable to them. Alex is right, a ban is a path to socialism.

FRB is not inherently fraud. So long as contracts are upheld there are no just grounds for legal action. The dilutionary effect upon the value of a unit of the currency is no more fraud than the application of the Law of Diminishing Marginal Value to an increase in the amount of specie itself is fraud. There is no *right* to a stability or predictability of the value of a unit of money.

Money is not created out of thin air, nor is it backed by “nothing.” It is created on the back of the bank’s acumen to judge loans and is backed by the value of those loans. They are real assets and can be sold for equally real money. Indeed, for a bank to have any net equity at all is by definition for its assets to be worth more than its liabilities, and its is all those assets that back those liabilities, with the residual being said owners’ equity.

But I am no fan of FRB. It is generally dumb. Highlights are:

The need for using deposits as a major source of loan-capital is a fallacy. Even today for instance, non-fractional sources of capital in Australia outweigh fractional sources by the order of sixteen or seventeen to one, last time I looked at the numbers (which admittedly has been a few years now). The ratio will climb higher still under laissez-faire even with free banking.

The need of FRB to increase intermediation rates is a fallacy, for the same reason. A financial system with that amount of capital is as allocatively efficient as it is going to get with or without the aid of FRB, especially under laissez-faire. This intermediation argument is also tantamount to the cynical attitude “it is easier to get forgiveness than permission” and so I treat it with the utter contempt it deserves.

The idle-cash argument is a fallacy, predicated on failing to recognise why people use money substitutes. The same amount of specie damn-well WILL end up in the vaults, “lying idle”, no matter how low the reserve fraction goes.

Yes, FRB is an instance of the practice of mismatch. But FRB is a special case, because of its relation to the money supply, so mismatch cannot be pointed to as the primary reason for FRB’s fault, though it contributes to the ephemerality and hence second-rateness of credit as a medium of exchange.

The core problem with FRB is failure to recognise that mere monetary and credit expansion does not and cannot increase the amount of real capital per capita, because it does nothing to change people’s time preferences nor improve the physical efficiency of real-capital use. Every attempt at demonstration that it does improve these things has always involved a violation of the ceteris-paribus condition and that it is something else to which the gains shown are truly due.

On top of that, the increase of the money supply by means of credit acts as a net detraction on real capital per capita. The unsoundness of FRB makes runs much more possible, which then can affect the rest of the economy because credit destruction reduces the money supply and upsets the validity of all prices. That makes life difficult for other banks whose unsoundness then also increases, leading to more runs and credit destruction, and so on cascade style, passing on their contagion. All this is set up for no benefit whatsoever. The omnipresent threat of this then occasions people to increase their general risk premiums attachable to hurdle rates for capital expenditures: the lower the reserve fractions the higher the risk premiums that it is rational to add. This lowers the total amount of maintainable real capital per capita, in return for ZERO upside.

So yes, FRB *IS* dumb. It has *nothing* to contribute to an economy that already has enough liquidity in its supply of specie. The sole redeeming feature of FRB is to be a second-rate source of liqudity in those rare cases when there is a bona-fide dearth of specie, as in the case of remote locations with poor communication (eg small townships in the back of beyond having little external trade) or where bad law hampers flow of specie (eg pre-revolutionary US colonies).

Pure empirical history will only show that fractions under laissez-faire will be much higher than they are today, but it cannot show why FRB is fundamentally worthless beyond those rare mitigating circumstances. The most you can get from empiricism is confirmation of how free banking is practical. To get to the heart of the matter one must look to capital-formation theory and the effects of monetary expansion on the vicissitudes of real capital. I often find that freedom-lovers who see nothing wrong with FRB are guilty of failing to learn Henry Hazlitt’s one lesson. Likewise, however, those who clamour for bans on FRB are equally blinkered, usually in thinking that the money is created out of thin air (it is not) and failing to recognise that credit is a bona-fide asset that it is perfectly legitimate to trade around and pay off one’s own debts with.

Last comment: what is really wanted is not merely safety deposit boxes, and I am not impressed with that dismissive comment. What is wanted is full-reserve deposit accounts while at the same time still having access of all kinds, such as to ATMs, cheque books, debit cards, internet banking, and so on. The two are not incompatible, and don’t even need a change in the procedural systems of a bank. All this needs is contracts specifying it, that one is a bona-fide depositor rather than a creditor, and there being yay much cash physically held to cover all accounts marked true-deposit as well as the reserves required for FRB accounts. Physically they’d be one fungible pile, but legally the depositors get first crack at the whole amount before anyone else of any kind gets a look-in because some of those funds is actually OWNED by the depositors. If there is not enough to pay back ALL depositors, then let *criminal* proceedings begin, whereas if all depositors are paid yet then the FRB “depositors” don’t get 100% then let *bankruptcy* proceedings begin.

Just for the record, despite Midwesterner’s dismissal, I still do not believe that money is created out of thin air through the credit creation process (it IS created out of thin air by the central bank though).

It is true though, that the credit creation process can have an inflationary effect, as people, for example, might borrow money to buy bangles, pushing up the price of bangles, and so reduce the value of your money in bangle terms. I guess this might be what Midwesterner meant. But as far as the bank is concerned, lending money to you constitutes credit/investment, whatever the money is used for. If this investment goes bad, there will be a bust after the boom. Ultimately long run inflation is due to the creation of M0 by the central banks; credit expansion/contraction is cyclical.(It is timely to point out here that the contraction aspect of the cycle may be too much to bear for policy makers, and it may lead them to print M0 – hence “quantitative easing”).

The key is to recognise that only M0 is money, really, and that higher M’s should more properly be regarded as investments. Money mutual funds for example are not technically part of the fractional reserve banking system since you can make a nominal loss on them, just as you can with bonds or equities (I think these alternative forms of financing may be what John McVey referred to in his Australian example). It would be much better if all non M0 money was in this form.

If I’ve read his post correctly, I think John are largely coming at this from the same angle.

Anyway, this is clearly a difficult topic over which seemingly well read and intelligent people can disagree. This means it is a prime candidate for being screwed up by the government (and I include the BoE in this), which, dare I say, is not populated by highly intelligent people, but rather people who think they are, and have a deep belief that the system works.

If you are interested in this topic Selgin has links to a few papers of his that I like on his website.

100 pieces of gold in a closed economy. All deposited in demand accounts in a bank, lent at fractional reserve of 10%. There are now 1000 virtual pieces of gold in circulation and 100 real pieces of gold in vaults. They are exchangeable at par. At least they are up until too many people get that idea at the same time. This is fractional reserve banking. Economy is now running as though there were 1000 pieces of gold. The virtual pieces can be exchanged for real pieces at par. If that is not ‘created out of thin air’ would somebody please give me a definition of what they mean when they say those virtual pieces of gold are not created out of thin air?

JJM did:

Money is not created out of thin air, nor is it backed by “nothing.” It is created on the back of the bank’s acumen to judge loans and is backed by the value of those loans. They are real assets and can be sold for equally real money. Indeed, for a bank to have any net equity at all is by definition for its assets to be worth more than its liabilities, and its is all those assets that back those liabilities, with the residual being said owners’ equity.

John, you appear to be equating the secured assets with the money lent against them. But if that were the case, there would have been no loan in the first place. In order for your statement “They are real assets and can be sold for equally real money.” to be true, an open market transaction must occur. In other words, in your (and FRB’s) construct, the value of money itself is at the mercy of the value of the stuff securing the fractional reserve created component of the virtual money. Money ceases to be a medium of exchange and becomes just another commodity floating with the rest.

Think of an economy as a double entry construct. On one side you have a medium of exchange and on the other side you have the stuff that is exchanged. Money needs to be as stable as possible otherwise instead of being a medium of exchange it becomes just one more thing to barter with. ‘Money’ and ‘stuff’ can never be interchangeable. However, ‘money’ can be dispensed with by turning it into ‘stuff’ and from that point on it becomes just one more variable in a floating pool of ‘stuff’.

You can’t just pick up some ‘stuff’, lift it across the line and call it ‘money’. Doing that requires a redefinition of ‘money’. ‘Money’ instead of being the very difficult to make more of ‘gold’ must now be redefined as ‘some gold and some stuff’. The stability inherent in the quantity of gold that makes it suitable for a medium of exchange is lost. Any fluctuations in the value of ‘stuff’ fluctuates the value of ‘money’ as well since ‘money’ now equals ‘gold plus some stuff’. No longer is ‘money’ a medium of exchange that allows you to step into and out of the marketplace, ‘money’ is now just one more market commodity. Its stability is lost and there is now no haven, temporary or lasting, from the vagaries of the market. Some economists may consider that a feature, not a bug.

As such, ‘money’ no longer being just gold but having become gold plus ‘stuff’ is at the mercy of the value of whatever ‘stuff” is added to the pool of ‘money’ via securitized expansion of the money supply. If the “real assets” securing that expansion where to crash (real estate, anyone?) then the pool of money itself would shrink. In other words, in your ‘collateral equals money’ world, there would be a monetary contraction aka “deflation”. That is the point at which the money masters turn up the TARPulus machinery.

Mid, re your last paragraph, I think that was one of PeterT’s specific points: when collateral values decline there should be monetary contraction (deflation), but politicians interfere to prevent the necessary correction from occurring, causing monetary inflation instead. (“that the contraction aspect of the cycle may be too much to bear for policy makers . . .”) That’s a flaw in the political process, not a defect in FRB or fiat currencies per se.

With your comment that ‘Money’ instead of being the very difficult to make more of ‘gold’ must now be redefined as ‘some gold and some stuff’, you implicitly seem to be saying that “gold = money”. You then go on to complain that (with FRB) money becomes “just one more market commodity”. But gold itself is just one more market commodity, as, indeed, is every other item which has been or could be used in its stead (silver, platinum, palladium, conch shells, whatever). Why do you suggest that “money” isn’t (or shouldn’t be) “just one more market commodity”? It is, and it should be. Money merely has the virtue of being a common denominator, an infinitely divisible good in terms of which the current “value” of all other goods can be expressed. And in a world of competing currencies (even with the relatively limited competition of today’s national fiat currencies, and certainly more so in a libertarian world of private currencies) that fact would be even more apparent.

“Fiat“, “fractional reserve banking” and “legal tender” are all of course different things. But so are “money” and “media of exchange“.

A true ‘medium of exchange; has no need to ‘correct’. If something needs to ‘correct’, then it is just one more commodity being bartered, not a medium of exchange. The fact that money under a FRB system behaves as a commodity to be bartered and not as a stable medium of exchange is evidence that FRB money is a commodity.

Gold does not equal money. Gold can equal money under certain circumstances but it doesn’t necessarily. Gold, unlike most commodities, is a relatively fixed quantity. Increases in the total amount of gold are slow, laborious and consume a lot of ‘stuff’ to achieve. And consumption, as in ‘beyond recovery’ destruction of gold is almost unheard of. This is why gold and a few other commodities are good candidates for media of exchange.

You may be inclined to say that all of that applies to real estate but in fact it does not. Real estate is not at all fungible. It is very much a product of its location. Gold is chemically indistinguishable.

Please notice I am drawing a distinction between “money” and “media of exchange“. “Money” is anything that is given the name “money“.

A “medium of exchange” is something that in and of itself has little consumption value, neither increases or decreases quantity in abrupt and arbitrary ways, and is universally fungible. And yes, to some extent I am conflating ‘medium of exchange’ with ‘measure of value’. But that is because I think a ‘medium of exchange’ has to be ‘measure of value’ that is stable over time. A medium of exchange would not be much good if its inconsistency required it to be converted instantly to retain its exchange weight. What good would a ‘meter’ be if it shrank and stretched in response to forces acting on it depending on when you used it?

Anything can behave like, in essence be a commodity, but only very few commodities can be media of exchange. Again, a meter or gallon or an ounce is not of much use if it stretches and shrinks in response to forces acting on it. To qualify as a ‘medium of exchange’ and a ‘measure of value’, a commodity must demonstrate a very narrow set of characteristics.

But gold itself is just one more market commodity, as, indeed, is every other item which has been or could be used in its stead (silver, platinum, palladium, conch shells, whatever). Why do you suggest that “money” isn’t (or shouldn’t be) “just one more market commodity”? It is, and it should be.

No, I disagree. It is not “just another“. Equating all commoditys’ characteristics is the equivalent of saying a tape measure should change its length under varying degrees of tension. Because clearly most commodities change their quantities in response to market pressures. Gold, etc does not significantly change its quantity.

Certainly the idea that money should behave as a commodity is a popular one and one we have been living under since the legal tender Fed notes were imposed. There are entire markets based on the idea of money as a speculative commodity (ForEx most notably). However, the idea of banning the use of a true media of exchange and compelling all to barter with what is essentially a fluctuating market commodity (which is what Fed notes are) is unsupportable.

I was inconsistent in my use of the term ‘money’ in my comment at July 31, 2011 03:57 PM.

Here is how a key part of it should read:

Think of an economy as a double entry construct. On one side you have a medium of exchange and on the other side you have the stuff that is exchanged. Moneya medium of exchange needs to be as stable as possible otherwise instead of being a medium of exchange it becomes just one more thing to barter with. ‘Money’a medium of exchange and ‘stuff’ can never be interchangeable. However, ‘money’a medium of exchange can be dispensed with by turning it into ‘stuff’ and from that point on itmoney becomes just one more variable in a floating pool of ‘stuff’.

You can’t just pick up some ‘stuff’, lift it across the line and call it ‘money’a medium of exchange . Doing that requires a redefinition of ‘moneya medium of exchange . ‘Money’a medium of exchange instead of being the very difficult to make more of ‘gold’ must now be redefined as ‘some gold and some stuff’. The stability inherent in the quantity of gold that makes it suitable for a medium of exchange is lost. Any fluctuations in the value of ‘stuff’ fluctuates the value of ‘money’ as well since ‘money’ now equals ‘gold plus some stuff’. No longer is ‘money’ a medium of exchange that allows you to step into and out of the marketplace, ‘money’ is now just one more market commodity. Its stability is lost and there is now no haven, temporary or lasting, from the vagaries of the market. Some economists may consider that a feature, not a bug.

Allow a free market in banking services and currencies and enforce the contracts that issuers of those currencies stipulate for those who choose to use them.

But, alas, I doubt that will happen until the current system is so weakened that the advantages of using black market currencies outweigh the consequences of violating legal tender laws. It will reach that point when the Fed note is so worthless that it can no longer pay off the voters who vote for, and the officials who enforce the will of the National authorities.

At least that is the way I see it shaking out. In the US I would not rule out the currency rebellion occurring as high as state governments seceding from the Fed note system. They will do that about the time that the entitlement system payouts cease to be worth the strings attached.

Right, so why on earth are we arguing abut FRB? I mean, it is an important question, but it clearly is not at the root of our current problems. You agree that it should not be banned in a free-market, no-central-bank, no-legal-tender environment, and so do both JMV and Peter T. The three of you also seem to agree that it is a stupid idea, even when legal. To me, it’s a bit like arguing whether using drugs or engaging in unprotected sex is a good idea. Similarly important questions, but similarly irrelevant to the question whether these activities should be legal or not.

The gallery, Alisa. There are a lot of people who don’t understand how we got in the mess we are in now. They think it was all speculators or something. They think we should stop worrying about banking and worry about the deficit or spending. Without the legal tender/fiat/fractional reserve banking system we could not have reached this point. It is only through the combination of those three things that the government and its proxies could drive us this far. There is a reason that the Fed System and income taxes arrived hand in hand and why gold was confiscated during the ‘New Deal’. And some of the ones that do understand how we got in this mess think the solution is to ban all FRB in some future utopia which is just a (non-obvious) foothold for collectivizing natural resources.

The answer to both groups is to better understand. Skipping the questions because a few of us here agree on the answer does nothing to expand general support for free banking. Free banking has been under determined attack for a very long time and it has been successfully blamed for things that were in fact caused by government enforced banking manipulation. Advocates for free banking need to make our case persistently, in detail with (as Arlo Guthrie said in Alice’s Restaurant, ‘The circles and the arrows’) and at every opportunity. If it bores you, just treat it like a cricket thread.

Mid, it doesn’t bore me at all – in fact, I personally find it fascinating. I just think that it puts the focus on the wrong issue. IOW, free banking – very important, FRB – not so much. And that, keeping both the gallery and the choir in mind.

Mid, I still disagree with you about money not being a commodity (or, more specifically, I think your attempt to differentiate between “money” and “medium of exchange”, for this purpose, is a distinction without a difference). I do agree that there is some benefit to the medium of exchange having a relatively stable value over time, but it’s not all-important and, in the end, is not even achievable. Slow, stable changes over time can easily be lived with, provided that people have time to adjust to them.

Besides, how can you be arguing for “free banking” and “a free market in currencies” on the one hand while claiming that “money” is not a commodity on the other? The two positions are inconsistant. To the extent people come to prefer one competing currency over others its relative value will increase vis a vis those others, which means that an equivalent amount of it will purchase more non-currency goods (more “stuff”) than will the others. It’s a commodity. Everything’s a commodity, all floating about in the great Equalibrium Sea, constantly bobbing up and down and adjusting its value relative to everything else. Money is no different.

Laird’s comment is absolutely bang on – I wish more people could understand the point he’s making. Everything is a commodity, either in practice or in potential: food, services, ideas – anything that has the capacity to perform some function for more than a single person can be transferred, sold and bought. The fact that the function money performs is a peculiar one (i.e. a medium which facilitates the trade in most other commodities) does not make it any essentially different from all those other commodities. And, just like other commodities, the line between its “normal” function (i.e. as medium of exchange) and its function as a commodity is very dynamic, because it is subject to human dynamics – in other words, it (the line) is constantly moving, subject to market forces. Now, we all know what happens when government steps into the market to meddle, imposing all kinds of rules and regulations: the “natural” dynamic is disrupted.

On of the ways in which government is meddling in a market is by assigning additional functions to products which they may or may not have assumed if left to market forces. Think of corn as an example: its “normal” function is to serve as food, but it also is a commodity (because it is functional as food to more than one person). The line between these two functions is dynamic – IOW, it is subject to market forces. All is well, until the government steps in, and decrees that corn is going to serve a new, unrelated function – in this case as car fuel. Note that the problem is not necessarily that corn should not, under certain circumstances, serve as car fuel (maybe it should or maybe it shouldn’t). Rather, the problem is that government (rather than the market) takes it upon itself to decide what those circumstances would be. The result is obvious: the “natural” line between corn as food and corn as commodity is disrupted, corn prices go up, food riots ensue, etc.

I don’t know what the money/FRB equivalent of the corn-as-fuel function is in this analogy – I am guessing maybe it is money also serving as an investment tool, but I could be wrong (duh, IANAB).

That said, I think that JMV made a very convincing argument that even under free-banking system FRB is not a brilliant idea. Whether that is true or not, however, is immaterial, as people should have the option to do non-brilliant things – as long as they pay the price.

Back to Mid’s argument: I still cannot tell whether it is true that FRB increases the money supply, because it seems to me that in order to answer that, we first need to determine which one of the functions performed by money do we mean when we say ‘money supply’? Is it as medium of exchange, or as an investment tool – or something else? In any case, I guess I’m taking my previous comment back, at least partly: FRB may be important to examine, in that it is another manifestation of government meddling and its negative effects on our lives. But, by the same token, we could say the same thing about the entire banking system: I think we would all agree that under free-market conditions, banking is a very useful tool – but, it seems to me, as things stand now, it is much more of a bug than a feature. So, similarly, FRB in itself is less of a problem than government meddling is.

To all those who think M3 means money is “created”, go try and withdraw all that M3! You cannot because it does not exist.

The issue here is, as the thread began, about informed consent by the depositor. An “on demand unless we can’t” account is the reality and I do think there is an argument to say banks must be open about this, otherwise it is a form of fraud*.

Banks do not create money, but they hold on-lent balances. A deposit with a bank is, unless you have a safe deposit box, a loan to that bank.

The absurdity of the “100% reserve” argument would be that ATMs and the ability to get your money out from another bank other than your branch would evaporate. Inter-branch is as inter-bank, in that netting off occurs and allows the system to operate. No, with 100% reserve YOUR cash MUST be in the vault and if you go to another bank then you cannot have any of their money because all of it belongs to other depositors just as if they had rows of safe deposit boxes.

If I am wrong and there is a practical, real-world answer to this issue I am very interested, but until then the 100% reservist movement is ignoring the simple solution (informed consent) and wants to use the lack to bounce in some other mechanism (which I do not believe will work) for some out of hatred of this fake “out of thin air” concept.

Next we will have interest bearing loans banned because people think there is never enough money left in the economy to pay off the principal + interest so more debt is needed (debt virus meme).

Half way to Upminster.

* we could divert here and say how woeful the State education system is that people leave school not knowing such things, not caring.

Peter T:
Yes, re capital. Noting though that institutions specialise for a reason, under laissez-faire there will be nothing stopping mutual funds being set up chiefly for gathering funds for SME direct lending, or banks setting up their own mutual funds for that purpose, and so on. The insurers also have lots of funds to work with, too. There are lots of possibilities here, all of which can operate simultaneously too, if we had laissez-faire. The bottom line is as I said: the argument about the need of using deposits for loan capital is flat out wrong.

Also, yes re the devaluation of a unit of money caused by monetary expansion. I completely disagree that it is fraudulent, because there is no difference in moral principle between expansion by specie and expansion by legally and equally morally created credit contracts. It does exacerbate the normal ebbs and flows of an economy into boom-bust cycles, but under truly free banking it is nothing to be worried about greatly as that is not a moral issue on par with the presence of central banking.

Mid:
My fault, yes. What I said comes from condensing volumes into a few hundred words and not getting it quite right. I did give the false impression that the loans made by the bank are used as media, which was wrong. Rather, it is the credit extended to the bank by FRB “depositors” that are the additional media of exchange. The value of *that* credit owed by the banks is then backed by the credit owed to the banks in their loan asset portfolio. The banks both owe and are owed, where it is what they owe that constitutes the expansion of the money supply when those unitised credits are exchangable among customers as means of payment. It is still not the case that the money (ie the new credits) are created out of thin air, because (in the absence of government, of course) the bank has to establish a history of prompt clearing and good credit judgement in order to have “depositors” be willing to bank with them.

Others have dealt with the commodity issue, so I wont cover that. This I will note, though:

If the “real assets” securing that expansion where to crash (real estate, anyone?) then the pool of money itself would shrink. In other words, in your ‘collateral equals money’ world, there would be a monetary contraction aka “deflation”.

I am not quite sure if you think you’re disagreeing with me, so I will just say: exactly! After a boom comes to its inevitable end, this is precisely what happens during a bust: destruction of credit leads because of bank failures leads to destruction of chunks of the money supply, which then means more businesses in the bank’s catchment area will suffer revenue failures, which then devalues the credit extended to them by banks in wider areas, which then endangers and eventually crashes more of these banks, which causes more credit destruction and more monetary contraction, and so on in a contagious cascade until its momentum is finally soaked up by banks’ equity buffers and the rise in effective reserve fractions reducing the impact of each credit crash. The phenomenon of depositor runs hastens both the crashes of credit and the rise of net fractions, so they are actually a good thing (as are all necessary corrections to eliminate malinvestments, just as the Austrians point out).

Alisa:
For me, the main two reasons are,

1) to understand how money, saving, financial capital (both equity and debt), real capital (the physical and intangible goods), rates of interest and profit, and banking practice are properly integrated both with each other and all other aspects of economic theory,

and 2) “the gallery” for both philosophical and sociopolitical reasons.

“Deposit multiplication is a wonderful thing. If these people got their way, the contraction in the money supply would be catastrophic. Hell-or-high-water libertarians make my teeth ache.”

Oh come off it. “Deposit multiplication” is a euphemism for printing money and creating credit out of thin air. If we did not boost the money supply by such dodges, we would not have the busts, and subsequent contractions.

I tell you what makes my teeth ache, and that is comments that say “deposit multiplication” is a splendid thing. It is not.

While agreeing that FRB probably shouldn’t be outlawed, in a free market how popular do you think it would be?

For instance, if the financial crisis has been followed by a catastrophic implosion of the banking system (no bail-outs), do you think people would want to put their money in these “risk-free” current accounts again? Or would they prefer fixed term loans and, god forbid, safe deposit boxes?

At present, when you deposit £1000 into your current account, the bank lends some of that money.

At present, the bank lends all of that money ten times over. £1000 of it goes to provide for someone’s mortgage, £1000 is lent to someone starting a business, £1000 of it is lent to another person starting a business, £1000 of it is lent to someone buying a car, £1000 is lent to someone making home improvements…

mdc said: “While agreeing that FRB probably shouldn’t be outlawed, in a free market how popular do you think it would be?

For instance, if the financial crisis has been followed by a catastrophic implosion of the banking system (no bail-outs), do you think people would want to put their money in these “risk-free” current accounts again? Or would they prefer fixed term loans and, god forbid, safe deposit boxes?”

So you can choose between an instant access cash account and a fixed term loan, with the same degree of risk and yield, what would you choose? For most people it is a no brainer. Clearly the deposit is preferable. FRB has a lot of advantages and these are basically the same as those of a single priced money market mutual fund. Instant access, certainty of price (i.e. no ‘breaking of the buck’ – usually you get at least your initial investment back). The fund could of course fall in value. The difference between a commercial bank and a money market mutual fund is that the latter can write down the value of its investments across the board, whereas the commercial bank cannot. The financial outcome of investing in a bank is much more binary – either the bank remains solvent or the government buys it and you still get your money back :-). There can still be an element of ‘being left holding the baby’ when a mutual money fund falls in value, but generally the cost of any bad investments is spread across investors. That is, unless the fund provider takes the cost, as Standard Life did in the crisis. They were going to write down one of their flagship cash funds by 5%, but after pressure from the industry they decided to top the fund up with cash from their reserves. Cost them in excess of £200m.

There is nothing wrong with FRB. It is government meddling that is the problem.

Alex I have no plan to “ban” fractional reserve banking – any more than I have a desire to ban 1+1=3.

However, I will continue to point out that 1+1 does NOT = 3 – and that there are bad consequences from operating on the assumption that it does.

If real savings (i.e. money that people earn but choose not to consume) are X (say a billion Dollars) then total lending can not be greater than X (can not be a billion and one Dollars – or two billion Dollars, or whatever).

Efforts to “get round” this basic point of logic have negative consequences (because objective reality is just that – objective, the universe exists independantly of what we would like it to be). No matter how clever (and ultra complex) the schemes to “expand credit” or “reduce interest rates” are.

Also money can not be in two different places at the same time – the Devil may have that ability, but money does not.

If a person saves one hundred Dollars and hands it over to be lent out, then that person NO LONGER HAS THE ONE HUNDRED DOLLARS (he can not use it to buy stuff with and so on) till when and IF he is paid back by the borrower or borrowers.

Now whether the saver lends the money directly or via a professional money lender (a bank) makes no difference to this.

A bank may take savings and store them (for a fee) safe deposit style – but then people can not (rationally) expect to be paid interest. On the contrary they must pay the banker for protecting their money from theft and so on.

In this context “free market deposit insurance” actually makes sense – for one is talking about money that is physically in the vaults, and one is talking about insurable risks (theft, fire, earthquake – and so on).

However, if people want interest they must accept that the money is going to be lent out – i.e. that it is NOT “a deposit” (is not in the vaults) and that they do not have this money any more till when (and IF) they are paid back.

The interest is partly payment for giving up the money for a period (time preference – I want the money now, you are prepared to give it up for a time, so I pay you for it) and partly payment for the risk of losing part or all of the savings.

“Deposit insurance” is hardly rational when one is not dealing with “deposits” (the money is not in the vaults) and one is dealing with BUSINESS JUDGEMENTS (what investments the money has been lent out to finance) – which is not an insurable risk.

I am sorry that in all the above I have stated what might correctly be described as “the bleeding obvious” – but it is all ignored so often that I must lay it all out.

As for the negative consquences of believeing that fantasy fairy castles in the air (i.e. that one can lend out more than there are real savings made available to lend out) are real castles that one can spend one’s life in…..

These consequnces are well known (as least to the Austrian School of economics).

First there will be a “boom” where (for no clear reason) business seems to prosper more than it did before – people will find themsleves getting rich (often off the back of asset prices – for example a property boom) without the hard “old fashioned” path of thrift, hard work and self denial.

But then the “boom” comes to an end – grim reality “The Gods Of The Copybook Headings” makes itself felt (like a man who jumps off a cliff and thinks he is flying – till he hits the ground). The “bust” has come.

The vast get-rich-quick scheme that is “expanding credit” always ends this way – it can end no other way.

There is no need to “ban” it – for it carries its punishment in its self.

People lose money, business enterprises fail, people lose their jobs and suffer greatly.

Of course some of the people who profited most from the “boom” will not be the ones to suffer when the (inevitable) “bust” comes (because they sold out when the markets were still high) – but that is the unfair nature of the universe (nothing the criminal law can fix).

The best thing government can do in a bust is – to cut (not increase) government spending, and to remove any regulations that hold up markets (including labour markets) from clearing – i.e. allow both prices and wages to fall.

Let the business enterprises (including banks – if they are still holding the package, when the music stops and the game of “pass the package” comes to an end) go bankrupt – real bankruptcy (close their doors) not a fake “managed bankruptcy”.

People lose their jobs and their savings – then they and their children have to start again (with their get-rich-quick dreams shattered).

That was actually the traditional American practice – for example as late 1921 Warren Harding followed traditional American polices (in the face of the collapse of the World War One and post World War One credit money expansion bubble) – he cut government spending and allowed prices and wages to fall (i.e. allowed markets to clear and malinvestments to be liquidated). The economy started to recover after six months.

Of course it woud be nice (very nice) if people would stop following complex (and often highly mathematical and “scientific”) get-rich-quick schemes – i.e. stopped engaging in credit expansion (i.e. lending out more savings than actually exist).

But I do not think it is going to happen.

People use drugs, they booze till their livers rot, they put shotguns in their mouths and pull the trigger, they try and lend out more savings than actually really exist (and on and on).

There is little the criminal law should try an do about such things.

As long as, of course, there is no deception involved.

For example, a bank must not say that money that is (in reality) lent out is “on deposit” – because it is not (it is not there).

It must be clear to customers that when they put their money in an interest account they are agreeing for this money to be lent out – i.e. that they are trusting the good, and careful, judgement of the bankers to not lose their investment.

Should business then turn against the bankers (by no fraud of their’s – by just bad judgement or simply bad luck) no crimial blame attaches to them.

The bank goes bankrupt (it closes its doors) and investors (not “depositors” – because money lent out is not “on deposit”, it is not in the vaults) lose their savings.

The only people who can (rationally) be covered by “deposit insurance” are people who actually have “deposites” (i.e. money in the vault) they are being insured against fire, theft and so on (and the insurerer can carry the burden of the insurance – because they know there are actual assets in the vaults that can be called upon if the bank goes bankrupt).

But, of coruse, a customer can not expect interest for such an account – on the contrary, he or she would (rationally) have to pay a fee for it.

Bankers have to earn a living (just like anyone else) and if they are not paid by their customers – then they have to seek income by wild complex credit bubble schemes.

It reminds me of people who complain about bad advice from an “investment adviser”.

My first question is “and how much did you pay this person for their advice?”

Normally the only response is a baffled look.

People do not seem to understand that if they (personally and directly) do not pay the “investment adviser” they are not dealing with an investment adviser at all – they are dealing with a salesman.

Language should be clear (things that are not deposites should not be called deposites, salesmen should not be called investment advisers – and so on).

But people also have a duty not to be daft.

“Buyer beware” and all that.

Only invest what you can afford to lose – and make as sure as you can that the money you do invest (i.e. make available to be lent out) is lent out by people of careful judgement (even if the interest rate they offer you is not very high). By the way… a major real investment of people (what should really help look after them in their old age) is their children – but that one of the lessons of the “Gods Of The Copybook Headings” that modern people (including me) ignore – and our civilization may well fall because of that.

Of course the whole price system is utterly distorted by the vast ammounts of funny money produced by government central banks (such as the Federal Reserve or the Bank of England).

Which means investors (savers) face a terrible choice.

Either invest in high risk banks (and so on) or earn virtually no interest at all – in low risk banks (and so on).

But in a free market things would be radically different.

Firstly prices would tend to fall over time (as better ways to do things were developed) so even money that was earning little or no interest (in a very careful bank) would, in reality, be making a decent return – as gold (or whatever was used as money) would not be increasing in line with increases in production.

But also there would not be this vast competition from the government central bank – pumping out credit money like lunatics and undermining the entire price system (and not just in investments).

I started thinking about this more carefully, and to help me understand it better I wrote a, fairly long, story about how the banking system emerges. This is fairly conventional monetary economics stuff, but I hope that what I have written may be of some interest. In particular, I hope it puts to bed the notion that FRB, as such, creates money ‘out of thin air’. It sort of tails off at the end…that’s because I thought I should post it before people lost interest in this post and comment thread. Anyway, enjoy…or endure perhaps.

Lets assume that we live in a barter economy. Lets assume further that everybody securitises the products they have produced and wish to offer to the market. Mr Baker issues Donut Obligations for example; Mr Farmer issues Cow Debt. Lets call these securities “promissory notes”. These pieces of paper represent real goods and can be sold for other real goods.

Now, there is also the case of investment to consider. Farmer Bob wishes to raise funds to buy potato plant seedlings, which he will plant in order to harvest potatoes 6 months later. He issues Potato Debt that is redeemable in 6 months time. He uses this to pay Farmer Jack for some seedlings.

Clearly this system is a bit impractical. Somebody comes up with the bright idea to pool all these promissory notes in a fund (“the Fund”). It is agreed before the inception of the fund that a) units in the Fund will be tradable freely on the open market, and b) the number of units that you receive in it will be equal to the value the market places on the promissory notes, in terms of Fund units. The Fund units become the medium of exchange of the economy. It is also possible, should you wish, to receive a pro-rata slice of the promissory note portfolio, in exchange for your units. Once the Fund recieves your units and hands you your slice of the portfolio, the units are extinguished.

The investors in the Fund decide to appoint a managing director of it. The new MD decides that, rather than exchange units of the Fund for promissory notes already in the market, the Fund will purchase promissory notes directly from their originators. Reusing the potato investment project example, Farmer Bob will borrow units from the Fund, and use the units to purchase the potato plant seedlings from Farmer Jack. The Fund has borrowed the Units it lent out from one of its depositors, or several. They are not created out of thin air.

The Fund eventually gets very large and difficult to value, so it is decided to fix the value of the units, not to the content of the Fund, but in terms of grams of gold. This seems reasonable enough to everybody. There is a ready market in gold; it is easy to value etc. The Fund is given an up to date valuation of its portfolio of promissory notes and then the switch is made. Note that not only the Fund units, but also the promissory notes are switched into gold terms. So it no longer has a claim on Farmer Bob’s potatos, but a fixed gold equivalent. Since the Fund’s liabilities (the units) are fixed, it makes sense to fix the assets as well. The Fund sells 5% of its assets for gold, which it keeps as reserves. Now, technically speaking, the bank has 5% reserves, 95% promissory notes, to 100% deposits. This implies a money multiplier ratio of 20 times. Does this mean that 95% of the deposits (“commercial bank money” in the parlance of the wikipedia FRB article) have been conjured up ‘out of thin air’? Obviously it doesn’t. The purpose of this story is to trace the outstanding supply of commercial bank money directly to real products and investments.

Now there are problems with the gold denomination. Gold prices prove very volatile, as one year there are more than the usual amount of weddings in India, with a surge in demand, and the next year a horde of gold is captured from the Spanish, increasing supply. In the first instance, the issuers of the promissory notes find it very difficult to raise the required amount of money to honour their obligations (in gold terms remember). Farmer Bob’s potatos no longer fetch as much as gold as they used to. This is deflation. In the second instance gold is much less scarce, and the potatos fetch rather more than they used to. This is inflation. After a while it is realised that the old system was not that bad after all. The gold standard is ditched and there is a return to the old system.

However, the MD decides to make one modification. You can no longer exchange your units for a slice of the portfolio of promissory notes. This is the birth of the fiat money system.

At this point the economy places a great deal of reliance on the Fund and its Units. Everybody is used to them, and this usefulness gives the Units a value beyond that of the Fund’s portfolio of promissory notes.

This includes the government, which decides that it would be a jolly good idea to demand that the Fund issues it with Units, in return for promissory notes of future repayment. A pretty good way of financing a war with Napoleon. While the Fund might wish to think twice about lending money to a non productive enterprise, it really doesn’t have much of a choice, and anyway, the government can raise the money required to repay it through tax. Its as good as if the country’s population had handed the Fund promissory notes for food, leather, and guns, and been issued with Units that they in turn handed over to the government. Nevertheless, no additional products are actually being produced, so the sudden increase in Units in circulation are instead absorbed by an increase in the price level. It takes time for the ‘news’ of the reduced value of the Units filters through the economy. The gun makers are at first delighted with all the extra business. Since they are first in line, they can use the Units the government gives them to buy other products at their old prices.

100 pieces of gold in a closed economy. All deposited in demand accounts in a bank, lent at fractional reserve of 10%. There are now 1000 virtual pieces of gold in circulation and 100 real pieces of gold in vaults. They are exchangeable at par. At least they are up until too many people get that idea at the same time. This is fractional reserve banking. Economy is now running as though there were 1000 pieces of gold. The virtual pieces can be exchanged for real pieces at par. If that is not ‘created out of thin air’ would somebody please give me a definition of what they mean when they say those virtual pieces of gold are not created out of thin air?

And I’ll repeat. A closed system. 1000 virtual pieces of gold. Each of them exchangeable at par for one ounce of gold. But there are only 100 ounces of gold. Whatever you have created, IT AIN’T GOLD! FRB created 900 ounces of gold out of thin air. All the talk about fund units and portfolios does not change the fact that there are 1000 vouchers each guaranteed redeemable on demand for 1 ounce of gold and there are only 100 ounces to cover them. THIN AIR. The vouchers are for gold, not for collateral or non-gold assets.

Midwesterner. While what you say is correct it is irrelevant. The vouchers are denominated in gold in the same way that distance is denominated in meters. Yes, yes, its exchangeable for gold, but this is only a relevant consideration in a bank run situation. As my example clearly showed, there are pretty deep problems with having the vouchers exchangable for something (gold) that bears no relation to the supporting economics (loans), and this is not something that I advocate. The solution is two fold: first, all time deposits should be able to ‘go up as well as down in value’, and in effect be money market mutual funds. Second, there should absolutely be no gold standard. However, demand deposits could be backed by high quality and highly liquid real investments. Metals and resources such as oil and gas would no doubt be included. It is a problem though that these have such volatile values. While I’m hardly a Keynesian, gold backed currency absolutely is a barbaric relic.

The “gold coins” examples are often cited but not an accurate parallel. They are, in effect, a three-card-trick to segue people from FRB into “fraud”. But it is inaccurate and misleading to use it.

When you deposit your gold pieces you get a scrip which is exchangeable at par and independent of the gold in the vault, but that is NOT what you get when you deposit cash in a bank. When you deposit under FRB, you get a statement (of your loan to the bank) that is worth zip. You cannot go into a shop and buy things with a statement.

If you want to spend that deposit, you in effect ask for your loan back. To meet that, the bank either gives you your un-lent deposit, calls in some of its loans or must borrow hard cash from elsewhere. That hard cash would have been surplus reserves elsewhere, i.e. deposits that were not lent, a recently repaid loan or similar.

Until the above borrowing by the bank occurs you have no money, only a loan to the bank. Once the bank makes good on your loan and returns it, no new money exists as that repayment was met by the borrowing of real high powered money or cash from elsewhere. You can only spend your balance by drawing directly or indirectly on unlent hard cash deposits.

Banks settle between each other not with electronic balances, but with the real thing. Of course there is netting off, which allows FRB to operate at the levels that it does, and it is this netting off which gives the appearance of more money just as the series of still images in a movie can give the appearance of motion.

If the bank did lend 10x deposits, what if the borrowers just took it out as cash? The bank would have to suck in hard currency from elsewhere to the value of the LOAN to meet those obligations. No new money.

What if that loan was spent by paying electronically? Then the depositor lends the bank which lends to the borrower who hands it over to a third party who then deposits it, thereby re-lending the money back to the bank.

The bank owes the two depositors, has one loan asset and one physical deposit.

That loan asset can be sold to someone for hard cash instead of that person just depositing it (i.e. an implied loan with a bank).

At all times the same amount of money exists. it moved from depositor to bank, to borrower, to seller and back to the bank again.

If I lent someone £5 who then lent a third £4, it does not mean that there is more money in the world. If I sold on that £5 loan to another, that would not create any new money either, for I would have £5 myself, but after taking £5 out of the wider economy. No new money, for I now have the £5 I used to have before lending it, but another now does not have the £5 they used to have as they just paid for the loan.

FRB puts money to work by putting it into or through the hands of those who believe they can make more use of it and are willing (they say!) to pay for the use of it.

After all is said and done the real proof will be for free banking to exist and those wanting 100% reserve to go lie in the bed they make for themselves.

I do not like to argue with you as, frankly, that would be a form of intellectual suicide, but can you explain if there is a direct link with FRB and the creation of these phoney instruments and can you give an example of such in use today?

Tim – sorry for not getting back to this post till now (and I am only here for another purpose).

For the details of the various scams (I mean manipualtions, I mean interesting methods of credit expansion) Midwesterner is your man.

Although the late Murry Rothbard was good on the methods of his own time (banking was one thing I did not oppose him on – although his use of the word “fraud” could be opposed, on technical grounds).

Can I link banking with credit expansion directly?

Yes I can – and so can you, and so can anyone who has ever used terms like “monetary base” and “broad money”.

Just stop and think what those terms MEAN.

After all if banks (FRB banks) just “put people’s savings to work”…..

There would be no difference between the “monetary base” (notes and coins – “MB”) and various forms of “broad money” (M2, M3 – M whatever).

What would happen is that savings would come into the bank and then (mostly) be lent out.

Still a “fractional reserve bank” but no increase in the money supply.

But that is not what happens.

The level of “broad money” (bank credit – lending) gets wildy out of line with the monetary base.

The numbers are not the same – the “broad money” (bank credit) number, is wildly bigger than the monetary base number.

But how can that be?

If the banks are just “putting people’s savings to work”.

Of course they are involved in credit EXPANSION.

Not from real savings (it is not a fractional reserve system in the sense of keeping a fraction and lending out the rest) but from nothing.

From air pies, fairy castles in the air (call it what you like).

One can use thousands of pages of technical languge to describe what is done – if one wishes to go raving mad. How various forms of debt paper are treated as “deposits” and money lent out on the basis of this “deposit” (and so on).

But the fact remains – the numbers are not the same. The “broad money” (the bank credit – the lending) is bigger (vastly bigger) than the monetary base.

Not vastly bigger than a fraction of it (as in “fractional reserve banking”) vastly bigger than ALL of it.

That is the scam.

That is the credit bubble – the difference between what money is lent, and what money actually EXISTS.

The scam is so huge that the human mind has trouble grasping it.

It reminds me of the people looking for a volcano in Yellowstone national park – they looked and looked, but they could not find the crater.

Then it suddenly dawned on them.

THE WHOLE PARK WAS THE CRATER.

It was a supervolcano.

Looking for the credit bubble is the financial system.

Looking for the “phony instruments”.

The whole system is the credit bubble.

It is that big. Central banking has allowed banks (and others) to start off with crazyness and then to build on crazyness (step by step) to something that is impossibly crazy (and of vast size – so vast that words have failed me as I type this).

I think its a matter of having a finite money supply vs. infinite supply.

And if you chose infinite, it is a question of who owns money. Who gets to issue it out of thin air and receive the interest as a steady income stream?

Fiat money, the result of FRB always deteriorates to nothing. That is what we’re seeing today. FRB is simply the industrialization of money lending at interest. Its okay if you do it occasionally as a single transaction. But when you make an industry of it, it is fraud.

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